A Financial-Fiscal Trilemma

Financial crises and sovereign debt crises are, of course, not a new phenomenon. But the strong connection between fiscal crises and financial crises is relatively recent, primarily developing since the Great Depression and especially since the 1980s. In a new and ambitious NBER working paper, Michael Bordo and Chris Meissner survey the literature on financial and fiscal crises and their interconnections, providing both a history of thought and a catalog of open questions.

The key to the growing link between fiscal and financial crises, they explain, is the increased use of government guarantees of financial institutions. This means that banking crises are often followed by a rise in the debt-to-GDP ratio that can be partially attributed to costs of reconstructing the financial sector. Based on a synthesis of the research in this area and some preliminary empirical analysis, Bordo and Meissner posit that countries face a “financial/fiscal trilemma.” As they explain:

This financial/fiscal trilemma suggests 43 that countries have two of the following three choices: a large financial sector, a large bailout package, and a strong discretionary reaction to the downturn associated with financial crises. The logic is as follows by way of an example. Assume a country with a large financial sector faces a banking crisis. If so, then the government can provide a bailout package of a size that is commensurate with the size of the financial sector. If so it uses up its fiscal space. Otherwise it could lower the size of the bailout and devote its fiscal space to discretionary fiscal policy. With a smaller financial sector, and the same amount of fiscal space, since the size of the bailout would by definition be smaller, the size of the rise in debt due to expansionary policy could rise (p. 42-43). 

They use data from Laeven and Valencia (2012) on 19 systematic banking crises to estimate the equation:

Fiscal costs refer to the fiscal costs of bailouts in the three years following a crisis. Discretion is the change in debt not due to the fiscal costs of bailouts, also in the three years following a crisis. The estimation results, with standard errors in parentheses, are:

Notice that the estimated coefficients on the fiscal cost and discretion to GDP ratios sum to approximately 1, suggestive of a tradeoff. If the financial sector is smaller, or if the bailout package is smaller, then the change in fiscal costs to GDP ratio is likely to be smaller, which could allow a larger change in the discretion to GDP ratio, hence the "trilemma." The trilemma is illustrated by Figure 5, below. The discretion to GDP ratio is on the y-axis and the fiscal costs of bailout to GDP ratio is on the x-axis. For a given change in the debt to GDP ratio, the regression estimates imply an "iso-line" showing the fiscal costs of bailouts and discretion to GDP ratios that are possible.

Source: Bordo and Meissner (2015)

As further evidence of the trilemma, they present Figure 6, which illustrates that countries with a larger financial sector, as measured by the domestic credit to GDP ratio, tend to have a larger rise in the share of the debt to GDP ratio explained by bailouts.

Source: Bordo and Meissner (2015)

This evidence of a new "trilemma" certainly merits more rigorous empirical evaluation. As the authors note, however, empirical studies of financial and fiscal crises face the challenge of inconsistent classification and measurement. Alternative crisis chronologies lead to contradictory results. Bordo and Meissner thus propose the following:

If economists and policy makers truly believed that crises were an important phenomenon to understand and possibly avoid then it might be the case that an independent crisis dating committee could help set the standard in much the same way the NBER business cycle dating committee works. The advantage of following this model is that the NBER is a respected non-governmental, non-partisan organization. Other organizations such as the IMF are not sufficiently politically independent. If crises are becoming increasingly global and crisis fighting is a global public good, then the importance of such a reform should be obvious. 

Politicians or Technocrats: Who Splits the Cake?

In most countries, non-elected central bankers conduct monetary policy, while fiscal policy is chosen by elected representatives. It is not obvious that this arrangement is appropriate. In 1997, Alan Blinder suggested that Americans leave "too many policy decisions in the realm of politics and too few in the realm of technocracy," and that tax policy might be better left to technocrats. The bigger issue these days is whether an independent, non-elected Federal Reserve can truly be "accountable" to the public, and whether Congress should have more control over monetary policy.

The standard theoretical argument for delegating monetary policy to a non-elected bureaucrat is the time inconsistency problem. As Blinder explains, "the pain of fighting inflation (higher unemployment for a while) comes well in advance of the benefits (permanently lower inflation). So shortsighted politicians with their eyes on elections would be tempted to inflate too much." But time inconsistency problems arise in fiscal policy too. Blinder adds, "Myopia is a serious practical problem for democratic governments because politics tends to produce short time horizons -- often extending only until the next election, if not just the next public opinion poll. Politicians asked to weigh short-run costs against long-run benefits may systematically shortchange the future."

So why do we assign some types of policymaking to bureaucrats and some to elected officials? And could we do better? In a two-paper series on "Bureaucrats or Politicians?," Alberto Alesina and Guido Tabellini (2007) study the question of task allocation between bureaucrats and politicians. In their model, neither bureaucrats nor politicians are purely "benevolent;" each have different objective functions depending on how they are held accountable:

Politicians are held accountable, by voters, at election time. Top-level bureaucrats are accountable to their professional peers or to the public at large, for how they have fulfilled the goals of their organization. These different accountability mechanisms induce different incentives. Politicians are motivated by the goal of pleasing voters, and hence winning elections. Top bureaucrats are motivated by "career concerns," that is, they want to fulfill the goals of their organization because this improves their external professional prospects in the public or private sector.

The model implies that, for the purpose of maximizing social welfare, some tasks are better suited for bureaucrats and others for politicians. When the public can only imperfectly monitor effort and talent, elected politicians are preferable for tasks where effort matters more than ability. Bureaucrats are preferable for highly technical tasks, like monetary policy, regulatory policy, and public debt management. This is in line with Blinder's intuition; he argued that extremely technical judgments ought to be left to technocrats and value judgments to legislators, while recognizing that both monetary and fiscal policy involve substantial amounts of both technical and value judgments.

Alesina and Tabellini's model also helps formalize and clarify Blinder's intuition on what he calls "general vs. particular" effects. Blinder writes:

Some public policy decisions have -- or are perceived to have -- mostly general impacts, affecting most citizens in similar ways. Monetary policy, for example...is usually thought of as affecting the whole economy rather than particular groups or industries. Other public policies are more naturally thought of as particularist, conferring benefits and imposing costs on identifiable groups...When the issues are particularist, the visible hand of interest-group politics is likely to be most pernicious -- which would seem to support delegating authority to unelected experts. But these are precisely the issues that require the heaviest doses of value judgments to decide who should win and lose. Such judgments are inherently and appropriately political. It's a genuine dilemma.

Alesina and Tabellini consider a bureaucrat and an elected official each assigned a task of "splitting a cake." Depending on the nature of the cake splitting task, a bureaucrat is usually preferable; specifically, "with risk neutrality and fair bureaucrats, the latter are always strictly preferred ex ante. Risk aversion makes the bureaucrat more or less desirable ex ante depending on how easy it is to impose fair treatment of all voters in his task description." Nonetheless, politicians prefer to cut the cake themselves, because it helps them get re-elected with less effort through an incumbency advantage:

The incumbent’s redistributive policies reveal his preferences, and voters correctly expect these policies to be continued if he is reelected. As they cannot observe what the opponent would do, voters face more uncertainty if voting for the opponent...This asymmetry creates an incumbency advantage: the voters are more willing to reappoint the incumbent even if he is incompetent... The incumbency advantage also reduces equilibrium effort.

An interesting associated implication is that "it is in the interest of politicians to pretend that they are ideologically biased in favor of specific groups or policies, even if in reality they are purely opportunistic. The ideology of politicians is like their brand name: it keeps voters attached to parties and reduces uncertainty about how politicians would act once in office."

According to this theoretical model, we might be better off leaving both monetary and fiscal policy to independent bureaucratic agencies. But fiscal policy is inherently redistributive, and politicians prefer not to delegate redistributive tasks. "This might explain why delegation to independent bureaucrats is very seldom observed in fiscal policy, even if many fiscal policy decisions are technically very demanding."

Both Blinder and Alesina and Tabellini--writing in 1997 and 2007, respectively-- made the distinction that tax policy, unlike monetary policy, is redistributive or "particularist." Since then, that distinction seems much less obvious. Back in 2012, Mark Spitznagel opined in the Wall Street Journal that "The Fed is transferring immense wealth from the middle class to the most affluent, from the least privileged to the most privileged." Boston Fed President Eric Rosengren countered that "The net effect [of recent Fed policy] is substantially weighted towards people that are borrowers not lenders, towards people that are unemployed versus people that are employed." Other Fed officials and academic economists are also paying increasing attention to the redistributive implications of monetary policy.

Monetary policymakers can no longer ignore the distributional effects of monetary policy-- and neither can voters and politicians. Alesina and Tabellini's model predicts that the more that elected politicians recognize the "cake splitting" aspect of monetary policy, the more they will want to redelegate it to themselves. Expect stronger cries for "accountability." However, the redistributive nature of monetary policy, according to the model, probably strengthens the argument for leaving it to independent technocrats. The caveat is that "the result may be reversed if the bureaucrat is unfair and implements a totally arbitrary redistribution." The Fed's role in redistributing resources strengthens its case for independence if and only if it takes equity concerns seriously.

Regime Change From Roosevelt to Rousseff

I've written another post for the Berkeley Center for Latin American Studies blog:

President Franklin Delano Roosevelt was elected in October 1932, in the midst of the Great Depression. High unemployment, severely depressed spending, and double-digit deflation plagued the economy. Shortly after his inauguration in March 1933, a dramatic turnaround occurred. Positive inflation was restored, and 1933 to 1937 was the fastest four-year period of output growth in peacetime in United States history. 

How did such a transformation occur? Economists Peter Temin and Barrie Wigmore attribute the recovery to a “regime change.” In the economics literature, regime change refers to the idea that a set of new policies can have major effects by rapidly and sharply changing expectations. A regime change can occur when a policymaker credibly commits to a new set of policies and goals.... 

In short, Roosevelt stated and proved that he was willing to do whatever it would take to end deflation and restore economic growth. As Roosevelt proclaimed on October 22, 1933: “If we cannot do this one way, we will do it another. Do it, we will.” 

Almost all politicians promise change but few manage such drastic transformation. In Brazil’s closely contested presidential election this October, incumbent President Dilma Rousseff won reelection with a three-point margin over centrist candidate Aecio Neves. Rouseff told supporters, “I know that I am being sent back to the presidency to make the big changes that Brazilian society demands. I want to be a much better president than I have been until now.” 

Rousseff’s rhetoric of “big changes” refers in large part to the Brazilian economy, which is plagued with stagnant growth, high inflation, and a strained federal budget. Brazil’s currency, the real, hit a nine-year low following Rousseff’s victory, and the stock market also tumbled. This market tumult reflects investors’ doubts about the Rousseff administration’s intention and ability to enact effective reforms. Investors viewed Neves as the pro-business, anti-interventionist candidate and are unconvinced that Rousseff will act decisively to restore fiscal discipline and rein in inflation. In other words, Rousseff’s talk of change is not fully credible in the way that Roosevelt’s was... 

Though Rousseff is taking some actions to improve business conditions, restore fiscal discipline, and reduce inflation, the problem is that they are being enacted quietly and reluctantly rather than being trumpeted as part of a broader vision of reform. The key to regime change is that the effects of policy changes depend crucially on how the changes are presented and perceived. Economic policies work not only through direct channels but also through signaling and expectations. For example, a small rise in fuel prices and a reduction in state bank subsidized lending may have small direct effects, but if they are viewed as signals that the president is wholeheartedly embracing market-friendly reforms, the effects will be much greater. So far, despite Rousseff’s campaign slogan — “new government, new ideas” — she hasn’t credibly committed to a new regime.

Read the complete article and my pre-election Brazil article at the CLAS blog.

People are Different: A Partial Bibliography

"Turns Out People Are Different, Say Economists" is the title of Brendan Greeley's new article at BloombergBusinessweek. He writes that "the idea that different families respond differently to the same event—that households are heterogeneous—is a relatively new way of looking at the economy." This claim prompted an interesting Twitter discussion about the origins and acceptance of heterogeneous agent economics and the relevance of this literature to policymakers.

The discussion prompted me to create a (very incomplete) bibliography of heterogeneous agent literature. I've separated it into Recent Papers, Classics, and Remarks by Policymakers. I will add to it as I come across or remember other papers. I will also add papers that people suggest via the comment section or Twitter.

Recent Papers

Heterogeneous Consumers and Fiscal Policy Shocks, by Emily Anderson, Atsushi Inoue, and Barbara Rossi (2013)

"unexpected fiscal shocks have substantially different effects on consumers depending on their age, income levels, and education. In particular, the wealthiest individuals tend to behave according to the predictions of standard RBC models, whereas the poorest individuals tend to behave according to standard IS-LM (non-Ricardian) models, due to credit constraints."

Household Balance Sheets, Consumption, and the Economic Slump by Atif R. Mian, Kamalesh Rao and Amir Sufi (2013)

"the 2007-09 housing collapse in the United States resulted in a very unequal distribution of wealth shocks due to the geographical concentration of ex-ante leverage and house price decline. We investigate the consumption consequences of these wealth shocks and show that the consumption risk-sharing hypothesis is easily rejected."

Is deregulating firm entry good for the workers? Which workers? by Ana P Fernandes, Priscila Ferreira, and L Alan Winters (2013):

"deregulating firm entry appears to boost competition and employment (and possibly aggregate income) but its gains seem largely to be reaped by better-off, better-educated workers."

Fiscal Policy and Consumption, by Tullio Jappelli and Luigi Pistaferri (2013)
"A different type of experiment is a balanced-budget redistributive policy whereby the government finances a transfer to the poor by taxing the top 10% of the income distribution. With a homogeneous marginal propensity to consume, a pure redistributive policy has no effect on aggregate consumption. However, with a heterogeneous marginal propensity to consume, the effect is positive and highest if the programme targets the very poor."

Inflation and the Price of Real Assets, by Monika Piazzesi and Martin Schneider (2012)

"This paper develops an asset pricing model with heterogeneous agents and incomplete markets to study the 1970s. The key elements of the model are that households differ by age and wealth and that all credit is nominal, so that inflation matters for bond returns and the cost of borrowing. Our empirical strategy is based on the idea that micro data on household characteristics can be used to directly parametrize household sector asset demand."

Monetary Policy with Heterogeneous Agents, by Nils Gornemann, Keith Kuester, and Makoto Nakajima (2012)

"monetary policy shocks have strikingly different implications for the welfare of different segments of the population. While households in the top 5 percent of the wealth distribution benefit slightly from a contractionary monetary policy shock, the bottom 5 percent would lose from this measure"

Using Agent-Based Models for Analyzing Threats to Financial Stability, by Richard Bookstaber (2012)

"Agent-Based Models...can make an important contribution to our understanding of potential vulnerabilities and paths through which risks can propagate across the financial system." (HT David Ballard)

Center for Economic Studies, U.S. Census Bureau Working Papers, Various Authors and Years

A collection of papers addressing macro questions with microdata (HT Ryan Decker)

Classics

Income and Wealth Heterogeneity in the Macroeconomy, by Per Krusell and Anthony A. Smith, Jr (1998)

"Among the models we study, those that come the closest to matching real-world wealth distributions are precisely models with heterogeneous preferences and incomplete markets."

Asset Pricing with Heterogeneous Consumers, by George M. Constantinides and Darrell Duffie (1996)

"a potential source of the equity premium is the covariance of the securities' returns with the cross-sectional variance of individual consumers' consumption growth."

Remarks by Policymakers

Inflation Expectations and Inflation Forecasting, speech by Ben Bernanke (2007)

"median measures of inflation expectations often obscure substantial cross-sectional dispersion of expectations. On which measure or combination of measures should central bankers focus to assess inflation developments and the degree to which expectations are anchored?"

Krugman and Plosser on Deleveraging

On March 6, 2013, Philadelphia Fed President Charles Plosser argued that low interest rates are actually causing people to save more, not less, because the income effect currently outweighs the substitution effect. In his words:

The conventional view is that by lowering interest rates, monetary accommodation tends to encourage households to reduce savings and thus consume more today. However, as I’ve noted, in the current circumstances, consumers have strong incentives to save. They are deleveraging and trying to restore the health of their balance sheets so they will be able to retire or put their children through college. They are behaving wisely and in a perfectly rational and prudent way in the face of the reduction in wealth.

In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small. And large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving. In my view, until household balance sheets are restored to a level that consumers and households are comfortable with, consumption will remain sluggish. Attempts to increase economic “stimulus” may not help speed up the process and may actually prolong it.

This reminds me of an article by Paul Krugman last year called Deleveraging Shocks and the Multiplier (Sort of Wonkish).

So, the simple but surely broadly correct story of the mess we’re in is that we had a period of excessive complacency about leverage, which came to a sudden end. Household debt in particular surged, then was suddenly perceived as excessive...

Leveraging up, other things equal, leads to high aggregate demand — but this can be and is in practice offset by the central bank, which can always raise rates. Deleveraging, on the other hand, can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried).

So far, Plosser and Krugman more or less agree. Households are deleveraging because they really want to deleverage, we're at the zero lower bound, and unconventional monetary policy is iffy. (As Plosser puts it, "We are operating in an uncertain environment and using nontraditional policies with which we have limited experience.")

Here's where the big, big difference comes in. Plosser also said that fiscal stimulus wouldn't work in this scenario because "large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving." Let's break this down.

An increase in the deficit raises both current income and expected future taxes. If the government spending multiplier is one, an increase in the deficit is neutral for consumption. So people consume the same amount they otherwise would have, and save the additional income to use to pay future taxes.Yes, large deficits encourage more saving, but without reducing consumption. In other words, they increase the total level of savings people have, but they decrease the rate of saving out of current income. The rate versus level distinction is important. If households follow some heuristic about a minimum theshold level of saving they want to achieve (e.g. make sure to have $5,000 saved in case of emergency), then they could reach that threshold quicker (and stop deleveraging) through fiscal stimulus. And that is just assuming the multiplier is one. Even better if it is larger...which of course brings us back to Krugman:

Now, the same thing that makes deleveraging so hard to handle also makes the fiscal multiplier larger than it is in normal times. Normally, expansionary fiscal policy is offset by monetary tightening, contractionary policy by monetary loosening. Hence the lowish multiplier estimates based on recent history. But if deleveraging has pushed you into a liquidity trap, there are no offsets...Start by provisionally assuming a frictionless world in which consumers have perfect foresight and perfect access to capital markets. In that case the multiplier should be exactly 1...A rise in government spending does mean higher expected future taxes — but it also means higher incomes right now, and those two effects should exactly cancel each other.

Now add in realistic frictions, notably households that are liquidity-constrained and/or use rules of thumb based on current income to make spending decisions. (By the way, as Gauti Eggertsson and I have pointed out, once you’re using a debt/deleveraging model you are already in effect assuming that many households face liquidity constraints). These frictions will mean that a rise or fall in current income due to fiscal policy will lead to at least some movement of consumption in the same direction. So we get a multiplier bigger than 1.

But I would add that this is not just a question of whether the multiplier is bigger than one. Whether or not the multiplier is bigger than one, in fact just as long as it is bigger than zero, fiscal policy will at least help people reach their level-of-savings targets quicker, if that is the way some people decide how much to save (which seems intuitively reasonable.) Unfortunately, as Meryl Motika pointed out in her post yesterday, we don't know enough yet about how people decide to save. And that's getting to be a highly pressing issue for both monetary and fiscal policy.

Forecast Errors and Fiscal Multipliers: What am I Missing Here?

Today Mark Thoma's blog has a link to a paper by Olivier Blanchard and Daniel Leigh called "Growth Forecast Errors and Fiscal Multipliers." They find that "fiscal multipliers were substantially
higher than implicitly assumed by forecasters." I hope someone else who has read the paper can help me understand one part of it that is confusing me. This is their primary claim:

Under rational expectations, and assuming that forecasters used the correct model for forecasting, the coefficient on the fiscal consolidation forecast should be zero. If, on the other hand, forecasters underestimated fiscal multipliers, there should be a negative relation between fiscal consolidation forecasts and subsequent growth forecast errors (pg. 1).

I wanted to model it to convince myself. Here is my model:

They run the regression with one year of data at a time, not many years of data. Forecasted consolidation can certainly differ from actual consolidation. From (2) then, I am confused about why "the coefficient on the fiscal consolidation forecast should be zero." I think I'm missing something simple. Can someone chime in?

Fiscal Cliff, Platinum Coin, and Reign of the Dollar

Almost two years ago, Barry Eichengreen published an op-ed called "Why the Dollar's Reign is Near and End." The article condenses many of the arguments of his book Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. He writes (my emphasis added):

Finally, there is the danger that the dollar's safe-haven status will be lost. Foreign investors—private and official alike—hold dollars not simply because they are liquid but because they are secure. The U.S. government has a history of honoring its obligations, and it has always had the fiscal capacity to do so. 

But now, mainly as a result of the financial crisis, federal debt is approaching 75% of U.S. gross domestic product. Trillion-dollar deficits stretch as far as the eye can see. And as the burden of debt service grows heavier, questions will be asked about whether the U.S. intends to maintain the value of its debts or might resort to inflating them away. Foreign investors will be reluctant to put all their eggs in the dollar basket. 

The recent fiscal cliff fiasco and the current debt ceiling and platinum coin issues make me wonder if Eichengreen's prophesy is coming closer to fruition. So I started by looking at the exchange rate of the dollar against some other currencies from 2011 onwards. I chose the Canadian Dollar (blue line) and the Australian Dollar (green line), since the IMF recently declared them official reserve currencies, and since they are not as contaminated by recent events as the Euro and the yen. Look at the very far right of the graph, and you see both series drop down. That means that the dollar lost value relative to those currencies. One U.S. dollar can buy less Canadian or Australian dollars than before. In other words, the U.S. dollar got weaker.

Let's zoom in and have some fun with Google. I looked at Google trends data for the term "fiscal cliff." Google Trends gives you a measure of search volume for a particular term over time. The thick green line is the search volume for "fiscal cliff" and the dashed line marks its maximum. Notice how, when concern about the fiscal cliff got really high, the dollar got weaker. After President Obama signed the bill on January 2, the dollar continued to weaken, though not as drastically (the flatter downward slope). This is just a "playing around" finding and obviously not econometrically rigorous, but lends some anecdotal evidence to Eichengreen's predictions. Severe fiscal problems are chipping away at the dollar's "exorbitant privilege." If you want to have some fun, try out making a similar graph with the search term "platinum coin."